MB0042 - Managerial Economics Semester – I Assignment Set-2

MB0042 - Managerial Economics Semester – I

Assignment Set-2

Q.1. Income elasticity of demand has various applications. Explain each application with the help of an example.

Answer:

Income elasticity of demand may be defined as the ratio or proportionate change in the quantity demanded of a commodity to a given proportionate change in the income. In short, it indicates the extent to which demand changes with a variation in consumer’s income. The following formula helps to measure Ey.

Original demand = 400 units Original Income = 4000-00

New demand = 700 units New Income = 6000-00

Generally speaking, Ey is positive. This is because there is a direct relationship between income and demand, i.e. higher the income; higher would be the demand and vice-versa. On the basis of the numerical value of the co-efficient, Ey is classified as greater than one, less than one, equal to one, equal to zero, and negative. The concept of Ey helps us in classifying commodities into different categories.

1. When Ey is positive, the commodity is normal [used in day-to-day life]

2. When Ey is negative, the commodity is inferior. For example Jowar, beedi etc.

3. When Ey is positive and greater than one, the commodity is luxury.

4. When Ey is positive, but less than one, the commodity is essential.

5. When Ey is zero, the commodity is neutral e.g. salt, match box etc.

Practical application of income elasticity of demand

1. Helps in determining the rate of growth of the firm.

If the growth rate of the economy and income growth of the people is reasonably forecasted, in that case it is possible to predict expected increase in the sales of a firm and vice-versa.

2. Helps in the demand forecasting of a firm.

It can be used in estimating future demand provided the rate of increase in income and Ey for the products are known. Thus, it helps in demand forecasting activities of a firm.

3. Helps in production planning and marketing

The knowledge of Ey is essential for production planning, formulating marketing strategy, deciding advertising expenditure and nature of distribution channel etc in the long run.

4. Helps in ensuring stability in production

Proper estimation of different degrees of income elasticity of demand for different types of products helps in avoiding over-production or under production of a firm. One should also know whether rise or fall in income is permanent or temporary.

5. Helps in estimating construction of houses

The rate of growth in incomes of the people also helps in housing programs in a country. Thus, it helps a lot in managerial decisions of a firm.

Cross Elasticity of Demand

It may be defined as the proportionate change in the quantity demanded of a particular commodity in response to a change in the price of another related commodity. In the words of Prof. Watson cross elasticity of demand is the percentage change in quantity associated with a percentage change in the price of related goods. Generally speaking, it arises in case of substitutes and complements. The formula for calculating cross elasticity of demand is as follows.

Ec =

Symbolically Ec =

Price of Tea rises from Rs. 4-00 to 6 -00 per cup

Demand for coffee rises from 50 cups to 80 cups.

Cross elasticity of coffee in this case is 1.6.

It is to be noted that –

1. Cross elasticity of demand is positive in case of good substitutes e.g. coffee and tea.

2. High cross elasticity of demand exists for those commodities which are close substitutes. In other words, if commodities are perfect substitutes For example Bata or Corona Shoes, close up or pepsodent tooth paste, Beans and ladies finger, Pepsi and coca cola etc.

3. The cross elasticity is zero when commodities are independent of each other. For example, stainless steel, aluminum vessels etc.

4. Cross elasticity between two goods is negative when they are complementaries. In these cases, rise in the price of one will lead to fall in the quantity demanded of another commodity For example, car and petrol, pen and ink.etc.

Q.2. When the opinion survey method used and what is is the effectiveness of the method.

Answer:

Survey Methods;

Survey methods help us in obtaining information about the future purchase plans of potential buyers through collecting the opinions of experts or by interviewing the consumers. These methods are extensively used in short run and estimating the demand for new products. There are different approaches under survey methods. They are

Consumers’ interview method:

Under this method, efforts are made to collect the relevant information directly from the consumers with regard to their future purchase plans. In order to gather information from consumers, a number of alternative techniques are developed from time to time. Among them, the following are some of the important ones.

a) Survey of buyer’s intentions or preferences: It is one of the oldest methods of demand forecasting. It is also called “Opinion surveys”.

Under this method, consumer-buyers are requested to indicate their preferences and willingness about particular products. They are asked to reveal their ‘future purchase plans with respect to specific items. They are expected to give answers to questions like what items they intend to buy, in what quantity, why, where, when, what quality they expect, how much money they are planning to spend etc. Generally, the field survey is conducted by the marketing research department of the company or hiring the services of outside research organizations consisting of learned and highly qualified professionals.

The heart of the survey is questionnaire. It is a comprehensive one covering almost all questions either directly or indirectly in a most intelligent manner. It is prepared by an expert body who are specialists in the field or marketing.

The questionnaire is distributed among the consumer buyers either through mail or in person by the company. Consumers are requested to furnish all relevant and correct information.

The next step is to collect the questionnaire from the consumers for the purpose of evaluation. The materials collected will be classified, edited analyzed. If any bias prejudices, exaggerations, artificial or excess demand creation etc., are found at the time of answering they would be eliminated.

The information so collected will now be consolidated and reviewed by the top executives with lot of experience. It will be examined thoroughly. Inferences are drawn and conclusions are arrived at. Finally a report is prepared and submitted to management for taking final decisions.

The success of the survey method depends on many factors:

1) The nature of the questions asked,

2) The ability of the surveyed

3) The representative of the samples

4) Nature of the product

5) Characteristics of the market

6) consumer-buyers behavior, their intentions, attitudes, thoughts, motives, honesty etc.

7) Techniques of analysis conclusions drawn etc.

The management should not entirely depend on the results of survey reports to project future demand. Consumer buyers may not express their honest and real views and as such they may give only the broad trends in the market. In order to arrive at right conclusions, field surveys should be regularly checked and supervised.

This method is simple and useful to the producers who produce goods in bulk. Here the burden of forecasting is put on customers.

However this method is not much useful in estimating the future demand of the households as they run in large numbers and also do not freely express their future demand requirements. It is expensive and also difficult. Preparation of a questionnaire is not an easy task. At best it can be used for short term forecasting.

Q.3. Show how price is determined by the forces of demand and supply, by using forces of equilibrium.

Answer:

Equilibrium between demand and supply price:

Equilibrium between demand and supply price is obtained by the interaction of these two forces. Price is an independent variable. Demand and supply are dependent variables. They depend on price. Demand varies inversely with price, a rise in price causes a fall in demand and a fall in price causes a rise in demand. Thus the demand curve will have a downward slope indicating the expansion of demand with a fall in price and contraction of demand with a rise in price. On the other hand supply varies directly with the changes in price, a rise in price causes a rise in supply and a fall in price causes a fall in supply. Thus the supply curve will have an upward slope. At a point where these two curves intersect with each other the equilibrium price is established. At this price quantity demanded equals the quantity supplied. This we can explain with the help of a table and a diagram.

Price in Rs	Demand in Units	Supply in Units	State Of Market	Pressure on price
30	5	25	D>S	P ¯
25	10	20	D>S	P ¯
20	15	15	D=S	Neutral
10	20	10	S>D	P ­
5	30	5	S>D	P ¯

In the table at Rs. 20 the quantity demanded is equal to the quantity supplied. Since this price is agreeable to both the buyers and the sellers, there will be no tendency for it to change; this is called the equilibrium price. Suppose the price falls to Rs.5 the buyers will demand 30 units while the sellers will supply only 5 units. Excess of demand over supply pushes the price upwards until it reaches the equilibrium position where supply is equal to demand. On the other hand if the price rises to Rs. 30 the buyers will demand only 5 units while the sellers are ready to supply 25 units. Sellers compete with each other to sell more units of the commodity. Excess of supply over demand pushes the price downwards until it reaches the equilibrium. This process will continue till the equilibrium price of Rs. 20 is reached. Thus the interactions of supply and demand forces acting upon each other restore the equilibrium position in the market.

In the diagram DD is the demand curve, SS is the supply curve. Demand and supply are in equilibrium at point E where the two curves intersect each other. OQ is the equilibrium output. OP is the equilibrium price. Suppose the price is higher than the equilibrium price i.e. OP2. At this price quantity demanded is P2 D2, while the quantity supplied is P2 S2. Thus D2 S2 is the excess supply which the sellers want to push off in the market, competition among sellers will bring down the price to the equilibrium level where the supply is just equal to the demand. At price OP1, the buyers will demand P1D1 quantity while the sellers are prepared to sell P1S1. Demand exceeds supply. Excess demand for goods pushes up the price; this process will go on until the equilibrium is reached where supply becomes equal to demand.

Changes in Market Equilibrium

The changes in equilibrium price will occur when there will be shift either in demand curve or in supply curve or both:

Effects of Shift in demand

Demand changes when there is a change in the determinants of demand like the income, tastes, prices of substitutes and complements, size of the population etc. If demand raises due to a change in any one of these conditions the demand curve shifts upward to the right. If, on the other hand, demand falls, the demand curve shifts downward to the left. Such rise and fall in demand are referred to as increase and decrease in demand.

A change in the market equilibrium caused by the shifts in demand can be explained with the help of a diagram.

Effects of Changes in Both Demand and Supply

Changes can occur in both demand and supply conditions. The effects of such changes on the market equilibrium depend on the rate of change in the two variables. If the rate of change in demand is matched with the rate of change in supply there will be no change in the market equilibrium, the new equilibrium shows expanded market with increased quantity of both supply and demand at the same price.

This is made clear from the diagram below:

Similar will be the effects when the decrease in demand is greater than the decrease in supply on the market equilibrium.

Q.4. Distinguish between fixed cost and variable cost using an example.

Answer.

1. Fixed costs

These costs are incurred on fixed factors like land, buildings, equipments, plants, superior type of labor, top management etc. Fixed costs in the short run remain constant because the firm does not change the size of plant and the amount of fixed factors employed. Fixed costs do not vary with either expansion or contraction in output. These costs are to be incurred by a firm even output is zero. Even if the firm close down its operation for some time temporarily in the short run, but remains in business, these costs have to be borne by it. Hence, these costs are independent of output and are referred to as unavoidable contractual cost.

Prof. Marshall called fixed costs as supplementary costs. They include such items as contractual rent payment, interest on capital borrowed, insurance premiums, depreciation and maintenance allowances, administrative expenses like manager’s salary or salary of the permanent staff, property and business taxes, license fees, etc. They are called as over-head costs because these costs are to be incurred whether there is production or not. These costs are to be distributed on each unit of output produced by a firm. Hence, they are called as indirect costs.

2. Variable costs

The cost corresponding to variable factors are discussed as variable costs. These costs are incurred on raw materials, ordinary labor, transport, power, fuel, water etc, which directly vary in the short run. Variable costs directly and proportionately increase or decrease with the level of output. If a firm shuts down for some time in the short run; then it will not use the variable factors of production and will not therefore incur any variable costs. Variable costs are incurred only when some amount of output is produced. Total variable costs increase with increase in the level of production and vice-versa. Prof. Marshall called variable costs as prime costs or direct costs because the volume of output produced by a firm depends directly upon them.

It is clear from the above description that production costs consist of both fixed as well as variable costs. The difference between the two is meaningful and relevant only in the short run. In the long run all costs become variable because all factors of production become adjustable and variable in the long run.

However, the distinction between fixed and variable costs is very significant in the short run because it influences the average cost behavior of the firm. In the short run, even if a firm wants to close down its operation but wants to remain in business, it will have to incur fixed costs but it must cover at least its variable costs.

1. Total fixed cost (TFC)

TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools & equipments in the short run. Total fixed cost corresponds to the fixed inputs in the short run production function. TFC remains the same at all levels of output in the short run. It is the same when output is nil. It indicates that whatever may be the quantity of output, whether 1 to 6 units, TFC remains constant. The TFC curve is horizontal and parallel to OX-axis, showing that it is constant regardless of out put per unit of time. TFC starts from a point on Y-axis indicating that the total fixed cost will be incurred even if the output is zero. In our example, Rs 360=00 is TFC. It is obtained by summing up the product or quantities of the fixed factors multiplied by their respective unit price.

2. Total variable cost (TVC)

TVC refers to total money expenses incurred on the variable factor inputs like raw materials, power, fuel, water, transport and communication etc, in the short run. Total variable cost corresponds to variable inputs in the short run production function. It is obtained by summing up the production of quantities of variable inputs multiplied by their prices. The formula to calculate TVC is as follows. TVC = TC-TFC. TVC = f (Q) i.e. TVC is an increasing function of out put. In other words TVC varies with output. It is nil, if there is no production. Thus, it is a direct cost of output. TVC rises sharply in the beginning, gradually in the middle and sharply at the end in accordance with the law of variable proportion. The law of variable proportion explains that in the beginning to obtain a given quantity of output, relative variation in variable factors-needed are in less proportion, but after a point when the diminishing returns operate, variable factors are to be employed in a larger proportion to increase the same level of output.

TVC curve slope upwards from left to right. TVC curve rises as output is expanded. When out put is Zero, TVC also will be zero. Hence, the TVC curve starts from the origin.

Q.5. Discuss Marris Growth Maximization model and show how it is different from the Sales maximization model

Answer.

Marris Growth Maximization Model

Profit-maximization is a traditional objective of a firm. Sales maximization objective is explained by Prof. Boumal. On similar lines, Prof. Marris has developed another alternative growth maximization model in recent years. It is a common factor to observe that each firm aims at maximizing its growth rate as this goal would answer many of the objectives of a firm. Marris points out that a firm has to maximize its balanced growth rate over a period of time.

Marris assumes that the ownership and control of the firm is in the hands of two groups of people, ie, owners and managers. He further points out that both of them have two distinctive goals. Managers have a utility function in which the amount of salary, status, position, power, prestige and security of job etc are the most important variables where as in case of owners are more concerned about the size of output, volume of profits, market share and sales maximization etc.

Utility function of the managers and that the owners are expressed in the following manner –

Uo = f [size of output, market share, volume of profit, capital, public esteem etc.]

Um = f [salaries, power, status, prestige, job security etc.].

In view of Marris the realization of these two functions would depend on the size of the firm. Larger the firm, greater would be the realization of these functions and vice-versa. Size of the firm according to Marris depends on the amount of corporate capital which includes total volume of assets, inventory levels, cash reserves etc. He further points out that the managers always aim at maximizing the rate of growth of the firm rather than growth in absolute size of the firm. Generally managers like to stay in a growing firm. Higher growth rate of the firm satisfy the promotional opportunities of managers and also the share holders as they get more dividends.

Marris identifies two constraints in the rate of growth of a firm:

1. There is a limit up to which output of a firm can be increased more economically, limit to manage the firm efficiently, limit to employ highly qualified and experienced managers, limit to research and development and innovation etc.

2. The ambition of job security puts a limit to the growth rate of the firm itself deliberately. If growth reaches the maximum, then there would be no opportunity to expand further and as such the managers may loose their jobs. Rapid growth and financial soundness should go together. Managers hesitate to take unwanted risks and uncertainties in the organization at the cost of their jobs They would like to avoid risky investment projects, concentrate on generating more internal funds and invest more finance on only those products and services which brings more profits Hence, managers would like to seek their job security through adoption of a cautious and prudent financial policy.

He further points out that a high risk-loving management would like to maintain a relatively low amount of cash on hand and invest more on business, borrow more external funds and invest more in business expansion and keep low profit levels. On the other hand, a highly risk-averting management may have exactly opposite policy. Ultimately, it is the job security which puts a constraint on business decisions by the managers.

The Marris growth maximization model. highlights on achieving a balanced growth rate of a firm. Maximum growth rate [g] is equal to two important variables-

1. The rate of demand for the products [gd]

2. Growth rate of capital[gc]

Hence, Max g = gd = gc.

The growth rate of the firm depends on two factors- a] the rate of diversification [d]and b] the average profit margin.

The diversification rate depends on the number of new products introduced per unit of time and the rate of success of new products in the market. The success of new products is determined by its changes in fashion styles, consumption habits, the range of products offered etc. More over diminishing marginal returns would operate in any business and as such there is a limit to diversification. Similarly, market price of the given product, availability of alternative substitute products and their relative prices, publicity, propaganda and advertisements, R&D expenses and utility and comparative value of the product etc would decide the profit ratio. Higher expenditure on sales promotion and R&D would certainly reduce profits level as there are limits to them.

The rate of capital growth is determined by either issue of new shares to obtain additional funds and external funds and generation of more internal surplus. Generally a firm would select the last one to avoid higher degrees of risks in the business.

The Marris model states that in order to maximize balanced growth rate or reach equilibrium position, there should be equality between the growth rate in demand for the products and growth rate in supply of capital. This implies the satisfaction of three conditions.

1. The management has to maintain a low liquidity ratio, ie, liquid asset / total assets. But this ratio should not create any financial embarrassment to meet the required payments to all the concerned parties.

2. The management has to maintain a proper leverage ratio between value of debts/Total assets so that it will have enough money to invest in order to stimulate growth.

3. The management has to keep a high level of retained profits for further expansion and development but it should not displease the shareholders i.e. by giving low dividends.

In this case, the mangers would maximize their utility function and the owners would maximize their utility functions. The managers are able to get their job security with a high rate of growth of the firm and share holder would become happy as they get higher amount of dividends.

Demerits

1. It is doubtful whether both managers and owners would maximize their utility functions simultaneously always

2. The assumption of constant price and production costs are not correct.

3. It is difficult to achieve both growth maximization and profit maximization together.

Q.6. Explain how fiscal policy is used to achieve economics stability.

Answer:

Fiscal policy:

During the period of inflation or uptrend in the economy, when the private enterprise is over enthusiastic and there is over expansion and over production government can use taxation and licensing policy as very effective instruments to check such unwieldy growth. Price control measures can be adopted. Government should adopt surplus budget, reduce public expenditure and resort to public borrowing. The cumulative result of these measures would reduce the supply of money in circulation, purchasing power and demand.

On the contrary, during the period of depression government should adopt deficit budget, Increase the volume of public expenditure, redeem public debt and resort to external borrowings, indulge in a moderate dose of deficit financing, reduce tax rates, grant subsidies, development rebates, tax-concessions, tax-relief’s and freight concessions etc. As a result of these measures, supply of money in circulation will increase. This in its turn would raise the purchasing power, demand for goods and services, production and employment etc. J.M. Keynes recommended a number of public works programmes to be launched by the government to cure depression. The New Deal policy of President Roosevelt in the U.S.A. and Blum experiment in France were based on this very belief.

Fiscal Measures

The following are some of the important anti-inflationary fiscal measures: -

1. Reduction in the volume of public expenditure.

2. Rise in the levels of taxes, introduction of new taxes and bringing more people under the coverage of taxes.

3. More internal borrowings by public authorities.

4. Postponing the repayment of debt to people.

5. Control on the volume of deficit financing.

6. Preparation of a surplus budget.

7. Introduction of compulsory deposit schemes.

8. Incentive to savings.

9. Diverting the public expenditure towards the projects where the time gap between investment and production is least, (small gestation period).

10. Tariffs should be reduced to increase imports and thus allow a part of the increased domestic money income to ‘leak-out’.

11. Inducing wage earners to buy voluntarily Govt., bonds and securities etc.

12. Thus, Fiscal measures succeed to a greater extent to contain inflation in its own way.